TLFeBOOK 1 Head iii Financial Engineering Principles A Unified Theory for Financial Product Analysis and Valuation Perry H. Beaumont, PhD John Wiley & Sons, Inc. 00_200306_FM/Beaumont 8/15/03 12:39 PM Page iii TLFeBOOK 00_200306_FM/Beaumont 8/15/03 12:39 PM Page iii TLFeBOOK Financial Engineering Principles 00_200306_FM/Beaumont 8/15/03 12:39 PM Page i TLFeBOOK Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more. For a list of available titles, please visit our Web site at www.WileyFinance.com. 00_200306_FM/Beaumont 8/15/03 12:39 PM Page ii TLFeBOOK 1 Head iii Financial Engineering Principles A Unified Theory for Financial Product Analysis and Valuation Perry H. Beaumont, PhD John Wiley & Sons, Inc. 00_200306_FM/Beaumont 8/15/03 12:39 PM Page iii TLFeBOOK Copyright © 2004 by Perry H. Beaumont, Ph.D. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or oth- erwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748- 6008, e-mail: permcoordinator@wiley.com. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied war- ranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please con- tact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data Beaumont, Perry H., 1961- Financial engineering principles: a unified theory for financial product analysis and valuation / Perry H. Beaumont. p. cm. — (Wiley finance series) Published simultaneously in Canada. ISBN 0-471-46358-2 (cloth) 1. Financial engineering. I. Title. II. Series. HG176.7.B42 2003 658.15’224—dc21 2003011338 Printed in the United States of America. 10987654321 00_200306_FM/Beaumont 8/15/03 12:39 PM Page iv TLFeBOOK For my wife, Alexandra, with love and devotion 00_200306_FM/Beaumont 8/15/03 12:39 PM Page v TLFeBOOK Currencies Bonds Equities 00_200306_FM/Beaumont 8/15/03 12:39 PM Page vi TLFeBOOK 1 Head vii FOREWORD IX PREFACE XI INTRODUCTION XVII PART ONE Products, Cash Flows, and Credits 1 CHAPTER 1 Products 3 CHAPTER 2 Cash Flows 15 CHAPTER 3 Credit 73 PART TWO Financial Engineering, Risk Management, and Market Environment 111 CHAPTER 4 Financial Engineering 113 CHAPTER 5 Risk Management 171 CHAPTER 6 Market Environment 241 INDEX 271 Contents vii 00_200306_FM/Beaumont 8/15/03 12:39 PM Page vii TLFeBOOK [...]... within a single diagram The concepts of products (bonds, equities, and currencies), cash flows (spot, forwards and futures, and options), and credit (products, cash flows, and issuers) are intended to represent more specific or micro-oriented considerations for investors Conversely, the concepts of financial engineering (product creation, portfolio construction, and strategy development), risk management... usually great, and I am most grateful to my wife, Aly, and my sons, Max, Jack, and Nicholas, for indulging their husband and father in this latest work Another dimension of this book is that during the time of its writing I had the good fortune to live and work on two continents and with global responsibilities These experiences provided considerable food for thought, and I am grateful for that I also... my own Finally, for their assistance with preparing this book, I want to thank Elena Baladron and Thomas Cooper xv TLFeBOOK TLFeBOOK 1 Head xvii Introduction This text presents, for the first time, a single unified approach to building bridges across fundamental financial relationships The top layer of this new methodology is comprised of products, cash flows, and credit Products are financial securities... offerings TLFeBOOK TLFeBOOK PART ONE Products, Cash Flows, and Credit TLFeBOOK TLFeBOOK CHAPTER 1 Products Bonds Equities Currencies his chapter provides working definitions for bond, equity, and currency, and discusses similarities and differences between bonds and equities T Bonds Perhaps the most basic definition of a bond1 is that it is a financial instrument with a predetermined life span that embodies... theoretical contexts and explore the implications In essence, such exploration is the mission of this text, which provides an innovative way to think about market linkages and synergies and sketches a practical blueprint that both students and practitioners can use for a variety of applications 1Franco Modigliani and Merton Miller, “The Cost of Capital, Corporate Finance, and the Theory of Investment,”... around for a long time and are commonly used, though they are woefully insufficient now as stand-alone concepts; they are much more valuable to investors when seen in broader context alongside other financial measures This text shows why and presents new ways that long-standing metrics of risk and return can be combined to assist with divining creative and meaningful market insights Figure P .1 presents... life span of 10 0 years 3 TLFeBOOK 4 PRODUCTS, CASH FLOWS, AND CREDIT Cash flows generally consist of periodic coupons and a final payment of principal Coupons typically are defined as fixed and regularly paid amounts of money, and usually are set in relation to a percent of the principal amount For example, if the coupon of a bond is set at 8 percent and is paid twice a year over five years, and if the... various classifications of bondholders and shareholders, and there are materially different priorities as to how these categories are rated and treated Chapter 3 delves into the nuances of what these classifications mean Figure 1. 1 presents a continuum of investment products that depicts investor rankings in an event of default Table 1. 1 summarizes this section on bonds and equities These characteristics... service, or payment, and in a timely fashion The chapter examines credit risk from the perspective of products, cash flows, and issuers Chapter 4 demonstrates intra- and interrelationships among the triangles presented in previous chapters and in a product creation context and shows how hybrids can be analyzed Indeed, with the new building block foundation, the text demonstrates how straightforward it can... capital structure and associated financial instruments is not necessarily a new idea, although it has become increasingly deserving of new and creative insights In an important paper written in 19 58 entitled “The Cost of Capital, Corporate Finance, and the Theory of Investment,” Franco Modigliani and Merton Miller first suggested, among other propositions, TLFeBOOK Introduction xxi that the financial instrument . Flows, and Credits 1 CHAPTER 1 Products 3 CHAPTER 2 Cash Flows 15 CHAPTER 3 Credit 73 PART TWO Financial Engineering, Risk Management, and Market Environment 11 1 CHAPTER 4 Financial Engineering 11 3 CHAPTER. at www.WileyFinance.com. 00_200306_FM/Beaumont 8 /15 /03 12 :39 PM Page ii TLFeBOOK 1 Head iii Financial Engineering Principles A Unified Theory for Financial Product Analysis and Valuation Perry H. Beaumont, PhD John. TLFeBOOK 1 Head iii Financial Engineering Principles A Unified Theory for Financial Product Analysis and Valuation Perry H. Beaumont, PhD John Wiley & Sons, Inc. 00_200306_FM/Beaumont 8 /15 /03 12 :39